Question

The balance sheets of Forest Company and Garden Company are presented below as at December 31, Year 8.

Additional Information
• Forest acquired 90% of Garden for $207,900 on July 1, Year 1, and accounts for its investment under the cost method. At that time, the shareholders’ equity of Garden amounted to $175,000, the accumulated amortization was $95,000, and the assets of Garden were undervalued by the following amounts:
Inventory......... $12,000
Buildings......... $10,000 remaining life, 10 years
Patents ......... $16,000 remaining life, 8 years
• During Year 8, Forest reported net income of $41,000 and declared dividends of $25,000, whereas Garden reported net income of $63,000 and declared dividends of $50,000.
• During Years 2 to 7, goodwill impairment losses totalled $1,950. An impairment test conducted in Year 8 indicated a further loss of $7,150.
• Forest sells goods to Garden on a regular basis at a gross profit of 30%. During Year 8, these sales totalled $150,000. On January 1, Year 8, the inventory of Garden contained goods purchased from Forest amounting to $18,000, while the December 31, Year 8, inventory contained goods purchased from Forest amounting to $22,000.
• On August 1, Year 6, Garden sold land to Forest at a profit of $18,000. During Year 8, Forest sold one-quarter of the land to an unrelated company.
• Forest’s bonds have a par value of $100,000, pay interest annually on
December 31 at a stated rate of 6%, and mature on December 31, Year 11. Forest incurs an effective interest cost of 8% on these bonds. They had a carrying amount of $93,376 on January 1, Year 8. On that date, Garden acquired $60,000 of these bonds on the open market at a cost of $57,968. Garden will earn an effective rate of return of 7% on them. Both companies use the effective-interest method to account for their bonds.
The Year 8 income statements of the two companies show the following with respect to bond interest.

• Garden owes Forest $22,000 on open account on December 31, Year 8.
• Assume a 40% corporate tax rate and allocate bond gains (losses) between the two companies.
Required:
(a) Prepare the following statements:
(i) Consolidated balance sheet
(ii) Consolidated retained earnings statement
(b) Prepare the Year 8 journal entries that would be made on the books of Forest if the equity method was used to account for the investment.
(c) Explain how a loss on the elimination of intercompany bondholdings is viewed as a temporary difference and gives rise to a deferred income tax asset.
(d) If Forest had used parent company extension theory rather than entity theory, how would this affect the debt-to-equity ratio at the end of Year 9?